Lesson 10 – Competence and investing biases

Lesson 10 – Competence and investing biases

Today, you will understand a critical investing principle called circle of competence. You will also understand common investing biases.

Competence

Competence is critical in investment success. In earlier lessons you have read about why it is important to understand a business before you jump to stock prices and valuation.

There are multiple industry sectors. Each sector has different business drivers. Some are affected by interest rates. Some not as much. Different sectors have different market characteristics and growth rates.

Sometimes there are businesses which don’t even fall neatly into one broad area. For example, there is a company called AVT Natural Products which sells marigold extracts (marigold is “genda phool” in Hindi, it is used in religious rituals).

Can you imagine one of the uses of this extract. Poultry farm owners feed it to hens.

Why?

It makes the yolk in the eggs that they lay “more yellow”!

Unbelievable right?

So, the prospects of AVT Natural Products are dependent on poultry farm sector growth in developed markets.

The big question is, do you understand the business properly? Not only for AVT, but for any stock that you study.

Developing competence

Competence in understanding a business can be developed by multiple ways,

Education and work experience – for example, if you work in the IT sector you surely know what’s the outlook for your company and competitors.

Reading – business dailies and magazines, investor communication, company websites, industry reports and broking house research reports if you skip the valuation section (for obvious reasons).

Speaking to people who work in the same industry as the company that you are studying can help you understand the business dynamics.

For consumer facing companies you can visit the market. For example if you are studying Cera Sanitaryware you can easily go to the local sanitary-ware store and check whether Cera’s basins, fittings and commodes are selling well.

Circle of competence

This is a principle that Warren Buffett follows. Don’t invest in what you can’t understand. If you don’t have an idea of the business, the company’s strengths, weaknesses, its competition, its outlook, you will be flying blind.

Its safer to stick to things that you understand when you invest. Keep increasing your knowledge of new business areas or companies before you commit money to investments.

Have a look at a small clip where Warren Buffet speaks on this principle.

Youtube link – http://www.youtube.com/watch?v=P1q6vgFefjY

Investing Biases

We like to believe that we are rational in our actions. But none of us is immune from biases which affect our investment decisions.

With time, you can understand your biases when they play out. But for that you need to be aware of the different biases that may strike. I have listed the big ones.

Anchoring bias

An anchoring bias is when you tend to make decisions based on some arbitrary facts or numbers which become a reference point in your head. Say you buy a stock at Rs. 220 and it falls to Rs. 120. There might be something negative which has caused the price to fall. But you continue to hold in the hope that it comes back to Rs. 220. Why? Is Rs. 220 a fair value.

No. Just because you bought it at Rs. 220. This doesn’t make sense but it is common behaviour in many investors.

Overconfidence

This needs no explanation. In real life it can cause trouble and so is the case with stock investments. Once you are overconfident you will not see information or viewpoints that run contrary to your beliefs.

Confirmation bias

Let me give you an example. I commit money to a stock on a whim. I start seeking facts which support my case for investing. I want to confirm what I have already “done”. If I do this, I will be a victim of confirmation bias.

Herd mentality

2006-2007 – Everyone says buy real estate stocks. They badly crashed in the crisis of 2008. Most have not recovered.

Jan 2008 – Everyone was talking about how hot the Reliance Power IPO is and how it surely will make money. It still trades below the IPO price in 2013. Its been 5 years since then. What a waste of money!

A herd is a dangerous place where actions are based on emotions. The lone outsider who questions the herd will also be pooh-poohed and silenced. It is later that the herd realises its mistake. By which time, it is usually too late.

Recency effect

This is when you pay too much attention to recent events and let them colour your investment decision-making for the future. For example, stock prices crashed so badly in 2008, that there were many stocks available for attractive valuations in 2009. Few nibbled at cheap stocks because of the fear of the recent crash. That was a good time to buy on the contrary.

Refer this E-Course to your friends if you have benefited from it

If you like this E-Course, share it with friends who will benefit. You can have better discussions on investing with them if they too read what you are reading. It is useful to get views and counter-views on any investment idea!